Debunking the China Story

Invest in China, you are told. China’s economy is booming. GDP growth is among the fastest in the world. Since China is growing faster than the rest of the world, it must follow that Chinese stocks are a good buy. That’s the pitch the pundits and promoters continue to make, but is it true?

Just this week China reported GDP numbers for 2010. Yes, somehow China, a country with a per capita income that is a fraction of U.S. per capita income manages to report GDP figures before us. Makes one wonder, but that’s a topic for another day. China’s real GDP growth came in at 10.3%—exceeding analysts’ estimates. The comparable U.S. figure is likely to come in near 3%. That’s a big differential. In nominal terms, economic growth was even stronger. China’s nominal GDP increased almost 17% in 2010.

The stock market must have surged on the better-than-expected growth figures. At least, one would have expected as must based on the pitch from the China bulls.

So how did Chinese stocks actually react to the GDP news? With a big thud. The Shanghai Composite Index tumbled almost 3% in one day.

Chinese stock investors are concerned that China’s economy is overheating. Despite government efforts to slow the economy, GDP momentum is accelerating and inflation remains stubbornly high. The concern is that policymakers may have to clamp down even harder to slow the economy. That could be unpleasant for the Chinese stock market.

The China bulls will likely tell you that the one-day sell-off in the Shanghai Composite was an overreaction to the GDP news. A one-day return doesn’t disprove the notion that Chinese stocks will provide superior returns because China’s economy is booming. That’s probably true, so let’s take a long-term view.

A decade’s worth of GDP data and stock-market returns should suffice. The chart below compares China’s annual nominal GDP growth rate to the Shanghai Composite Index. The blue bars are nominal GDP growth, the black line is the Shanghai Composite, and the grey horizontal line is the average growth rate of nominal GDP over the last decade.

If the China bulls are right, my chart should show a strong correlation between nominal GDP growth and Chinese stock returns. It doesn’t. Over the last decade, GDP growth averaged 14.6% while the annual total return of the Shanghai Composite Index was only 4.63%. Investors would have fared better by investing in a slower-growing developed country such as Canada. Canadian stocks compounded at 6.57% over the last 10 years.

Crafting a global portfolio based exclusively on economic growth is a perilous strategy. Economic growth in China is robust, but many other factors are alarming. I continue to avoid direct investment in China, and I advise the same for my subscribers and investment management clients.